Low Prices Can Be Bad Too

October 23, 2008

Low prices can be bad, too

Bill Dickens
My View

Since January 2007, many Florida motorists have been outraged by soaring gas prices. Consumer anger was further intensified after Exxon-Mobil reported record profits in the second quarter of 2008.

Economists argued that the price spike was basically a temporary price increase created by supply bottlenecks in oil-refinery activities combined with speculative trading in the oil futures market. With refineries operating at normal capacity, this would lead to increased output and a return to pre-Katrina price levels.

Recent events appear to vindicate the price determination model for gasoline. According to the American Automobile Association (AAA), in August 2007, the average price of unleaded regular gasoline in Tallahassee was $3.83 per gallon. A year later, after area gas prices spiked to $4.25, the price of unleaded regular gasoline in Tallahassee has declined to $3.70.

Smart gas shoppers can find "cheap" gas for as low as $3.66, and that's not including low-cost retail chains such Sam's Club, Costco or Wal-Mart. Driving to Thomasville, Ga., to take advantage of favorable interstate gas price differentials is suddenly unnecessary.

It may not be too farfetched to see unleaded gas prices break the $3.50 per gallon floor. Happy days seem to be here again. With price forecasts like this. who could find any problem with this outcome?

Unfortunately, falling prices for key commodities such as gasoline can be both a blessing and a curse. This is due to the peculiar rationing function of prices in a market economy. Flexible relative price changes are necessary to achieve market efficiency. When supply increases for a commodity such as oil, the declining relative price of oil causes consumers to increase oil consumption. Market equilibrium will be prevented if demand is growing faster than supply.

These new rounds of gas price reductions will accelerate consumption and discourage motorists from conserving gasoline. Neither is a desirable long-term strategic choice. Combined with regulatory constraints (a moratorium on new refineries and off-shore drilling) and high Florida state gas taxes (30 cents per gallon), it is no surprise that lower prices at the pump will create an inconvenience for consumers.

Consider the following real-life example: A gas station on Mahan Drive last week posted the price for unleaded regular gas at $3.80 in the morning, but by 5 p.m. no more gas of that grade was available. Motorists were required to drive to another station or purchase more expensive gasoline grades. This example illustrates that inexpensive gas does not translate into gas availability.

Prices have a Janus-face quality that even intelligent commentators tend to overlook. Essentially, we want price relief for key commodities. Economics teaches that prices have a dual function: to allocate scarce resources and to distribute income across economic participants. Consumer calls for lower gas prices must be balanced with pecuniary incentives needed to stabilize oil refinery and extraction activities. Profligate consumption of fossil fuels to meet our insatiable taste for automobile driving convenience is socially irresponsible.

In short, cheap gas is like cheap whiskey. Both encourage reckless behavior. Economics is the so-called dismal science, because it is concerned with equilibrium behavior induced by efficient prices. Discussion about just or fair prices is better suited for Aristotelian philosophers or Tibetan monks. We would be wise to keep that distinction in mind the next time we fill up our tank.


Bill Dickens
253-502-8553 Phone
253-502-8628 Fax

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